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Europe & Market Legal Framework

Digital finance package: the innovations introduced by EU

The European Commission presented a new Digital Finance package on 24 September 2020. It is a package that is positioned at both a strategic and regulatory level and which overall aims to standardize financial services regulations and support their digital development in order to produce concrete benefits for both citizens and businesses. All this by seeking to ensure financial stability, respect for privacy and the fight against money laundering.

The corpus of the digital finance package is developed along four main lines: the Digital Finance Strategy, the Retail Payments Strategy, legislative proposals for a common regulatory framework at EU level on crypto-assets and a proposal for a regulatory framework on operational resilience.

The Digital Finance Strategy

The Digital Finance Strategy aims to stimulate the digitalisation of financial services, stimulating innovation and competition between the various competitors in the European Union, whether they are traditional operators or from the digital world, i.e. the Fintech sector. The strategy is based on the “same activity, same risk, same rules” principle, creating a level playing field between all financial services providers. A further objective is to ensure that the new financial environment supports the new industrial strategy for Europe and encourages the development and growth of highly innovative digital startups.

The strategy considers digital innovation a pillar in the world of finance. In fact, it is now clear that innovations based on Distributed Ledger Technology, artificial intelligence, but more generally those based on Information and communication technology (ICT), are able to improve services for consumers and businesses that therefore benefit from easier access to financial services and greater control over their assets. The push towards a European financial area that promotes Open Finance also implies the proposal of a European digital finance platform: by 2024 the European Commission envisages the introduction of new licences with an EU passport that will allow the birth of a European digital platform.

The Retail Payments Strategy

The second theme of the digital finance package presented by the European Commission is the Retail Payments Strategy: the strategy for innovative retail payment services and solutions.

The objective of the European Commission is to achieve a homogeneous retail payment system across the European Union that includes solutions for instant cross-border payments. This strategy should therefore ensure digital, immediate and efficient payment systems, operating at pan-European level, creating innovative and potentially more competitive retail markets.

Markets in Crypto-Assets (MiCA)

The European Commission presented on september 24th, 2020 a new legislative package to support Digital Finance, the so-called Markets in Crypto-Assets (MiCA) regulation which aims to achieve a regulation of crypto-assets (digital identity, open Finance, stablecoin, blockchain-based assets), applicable at European level in all member States, which should come into force by the end of 2022. This is the most extensive regulation of digital assets ever made to date and seems to promise great opportunities in terms of development and growth for the entire financial ecosystem.

The European Commission aims to reduce the legal fragmentation of the digital market that still exists among many EU member States. Before the MiCA agreement, companies operating at national level often had to adapt their international business to the financial policy of each Country and this entailed high costs. This regulation, which is directly applicable throughout Europe, can concretely reduce the difficulties faced by Fintech service providers. In addition, the greater uniformity of the European financial regulatory framework will promote a level playing field between financial operators, which is lacking when heterogeneous regulations coexist.

The regulation introduces the possibility to define a pilot regime for crypto-assets, tokens, and Distributed Ledger Technology solutions for the capital market like tokenized securities, trading and post-trading and the reclassification of token, stablecoin and CBDC definitions. In these experimental environments both the technological infrastructure and the adequacy of regulations can be put to the test.

Digital resilience framework

The regulatory framework on the digital resilience of technological solutions in the financial sector is designed to contribute to the increase in operational security safeguards. In essence, every company operating in the financial sector will need to ensure that it is able to cope with or limit the damage caused by any type of cyber- attacks or disasters related to its technological infrastructure.

New challenges and risks

The regulatory framework of the digital finance package highlights new challenges related to digital finance that are necessarily associated with potential risks to be faced: first and foremost that of financial stability, which is more complicated to safeguard when the digital component comes into play, as well as the protection of privacy, consumer safety and the integrity of the financial market. The European Commission will therefore propose by mid 2022 the necessary adjustments to the existing legislative framework for financial services with regard to consumer protection and appropriate rules to protect end users from the risks of digital finance, safeguard financial stability, protect the integrity of the EU financial sector and ensure a level playing field.

Although the digital finance package has just been presented, it shows great opportunities and a regulatory principle for crypto-assets that could soon put them on the same level as existing traditional financial products.

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Europe & Market Legal Framework

What is the Central Bank Digital Currency

From cryptocurrency to CBDC

The traditional monetary and financial context was faced, just over 10 years ago, with the advent of Bitcoin, a peer-to-peer digital currency system in which the latter can be transferred without the intervention of an intermediary relying on a shared protocol between the network participants based on Distributed Ledger Technology (DLT) and Blockchain. Bitcoin has thus introduced an innovative ecosystem based on completely new logics, initiating the world of cryptocurrency and disintermediation by solving the problem of trust in the counterpart. The revolutionary features of the DLT allowed the birth of the token economy, based on the “tokenization” of physical or monetary assets, thus shifting part of the physical economy of the digital world through the Blockchain itself.

The idea behind cryptocurrencies, the creation of a private digital currency, has inevitably led the monetary context and financial institutions to perceive a potential threat to their business model: banks feel defrauded of their institutional role and total digitalization through cryptocurrencies is also perceived by institutions as a risk for clients.

For example, the advent of stablecoins, the cryptocurrencies that ontologically have the characteristic of price stability, has aroused great interest from the public, but many doubts on the governments and central banks side, this was clearly observed in particular when Facebook announced the project for a private stablecoin, the Libra Coin.

Central banks have therefore felt the need to explore innovative solutions to limit the loss of control of the system: their response to the rapid spread of these new innovative models lies in the introduction of the Central Bank Digital Currency (CBDC) concept, a new form of digital currency released by central banks as a complement or substitute for fiat currency. Many central banks are studying, and in many cases experimenting with, this kind of solution, the adoption of which may take place in the coming years with different timeframes and implementation models.

The CBDC is therefore a concrete response to the crypto wave. The interest of central banks in digital currency has therefore progressively increased in recent years, driven by the desire to secure control over the money supply, while offering a modern payment system that is part of the digitalization process that is spreading at all levels.

CBDC features

The CBDC is a new form of currency that allows anyone to make electronic payments using digital currency and can be classified into two categories depending on who has access to it: the wholesale CBDC, whose use is limited to financial institutions and the interbank market, or the retail CBDC, designed for universal use involving direct public access to central bank liabilities.

A CBDC thus combines the characteristics of a legal currency issued by a state or central bank with certain characteristics of cryptocurrencies.

Advantages and disadvantages

CBDC offer some positive aspects: efficiency, for the convenience and ease of payments similar to cash payments, accessibility, for ease of access by anyone who wants to use it, resilience, due to the redundancy of the technological infrastructure, especially in the case of decentralized architecture, and interoperability necessary for conversions to other CBDCs and international payments.

The CBDC also guarantees financial inclusion and some consumer protection: unlike banking liquidity and reserves, the retail CBDC gives central banks the role of trusted lender for households and small businesses. This means that in a potential financial crisis, central banks will be able to provide support directly to clients, ensuring greater financial stability. The latter is undoubtedly an indispensable dimension that the CBDC would ensure: a government-supported digital currency that is widespread in the domestic market limits the possibility of adopting private digital currencies as stablecoins that pose a risk in the financial and monetary domain.

While recognizing many advantages, one of the CBDC’s weaknesses is its lack of anonymity, which can never be equivalent to cash or cryptocurrency anonymity.

CBDC and retail banks

The CBDC and its features are highly dependent on the real interests of consumers, so they must ensure an efficient and accessible system that can be a valid response to market demands. For this reason, the currency promoted by central banks must be a modern payment system that must be based on DLT and blockchain: the ease of money transfer without intermediaries and the low costs that they guarantee make its use indispensable. The issuance of digital currencies by central banks can have many advantages for users, but its impact on the banking system could be negative for retail banks: if consumers can hold money directly from the central bank, the function of retail banks would be at risk and this could cause the crisis of the traditional financial environment. The possible massive adoption of CBDCs would lead to a reduction of assets managed by retail banks, endangering the private credit system with potential consequences on business credit and therefore on employment.

For this reason, ongoing studies and experiments are mainly aimed at understanding the best way to implement CBDC to avoid the system destabilization but giving concrete benefits for consumers.